- Exxon Mobil has proven to be the most resilient oil and gas producer in the downturn.
- But oil could move higher, which could lead to Exxon Mobil’s underperformance vs. independents.
- While I believe that this line of thinking makes sense, it can also be dangerous.
Last year was a tough one for the energy industry. As the prices of international benchmark Brent crude and US benchmark WTI crude dropped by more than 30% each in 2015, the energy sector, as measured by SPDR Energy Select Sector ETF (XLE), dropped by almost 25%. But shares of Exxon Mobil (NYSE:XOM), the world’s largest publicly traded energy company in terms of production and market cap, fared better, with the company’s stock dropping by almost 16% in the corresponding period. Exxon Mobil has proven to be one of the most resilient energy companies in the downturn. This is evident from the fact that the Irving, Texas-based company has managed to remain profitable throughout the downturn, even as virtually the entire oil and gas exploration and production sector slipped into the red.
However, the oil price environment has improved this year. The prices of Brent and WTI have climbed 23.6% and 17.9% respectively since the start of this year. Recently, the oil price has been buoyed by hopes that the world’s major oil producing countries, particularly OPEC members and Russia, will agree to freeze future production when they meet on Sept. 28 in Algeria, which could ease the supply glut. That may have a positive impact on oil prices which could continue moving higher.
If oil continues to rise, then Exxon Mobil’s refining business, which reported a profit of $1.7 billion in the first half of 2016, which was significantly greater than a profit of $218 million from the oil and gas exploration and production business, could come under pressure given the unit usually reports lower profits when oil prices increase. That’s because the refining business uses crude oil as a raw material, therefore, any increase in the commodity’s price increases the unit’s cost of production and negatively affects its profit margins.
As a reminder, Exxon Mobil’s refining business, also called downstream business, is so large that it is at par with some of the world’s biggest stand-alone refiners, such as Valero Energy (NYSE:VLO). Exxon Mobil’s Baytown refinery in Texas, for instance, can process up to 584,000 barrels of crude oil daily, which makes it the second biggest US refinery.
Besides, Exxon Mobil also has a large chemicals business under which it offers a large variety of petrochemical and polymer products. In fact, this business, which reported a profit of $2.6 billion in the first half of 2016, is big enough to make Exxon Mobil Chemical one of the largest petrochemical companies in the world.
Due to a large portfolio of refining and chemical businesses, Exxon Mobil does not have as big of an exposure to oil prices as other pure-play oil and gas producers, like ConocoPhillips (NYSE:COP) and Anadarko Petroleum (NYSE:APC), that get nearly all of their revenues and profits from oil and gas production. These independent oil and gas producers could be the bigger beneficiaries of an upturn in oil prices than the vertically integrated Exxon Mobil. As a result, their stocks could outperform Exxon Mobil.
In other words, although Exxon Mobil stock has performed well in the downturn, it could underperform in an environment of rising oil prices. While I believe that this line of thinking makes sense, it is certainly not for the faint-hearted.
Oil price environment
That’s because, despite all the optimism, the oil price environment will likely remain volatile. Remember that although some OPEC members and Russia have frequently talked about stabilizing production in order to support oil prices, it is highly unlikely that the talks will result in any constructive agreement. That’s because the latest meeting is actually an informal talk that is happening on the sidelines of International Energy Forum. In fact, OPEC’s secretary-general Mohammed Barkindo has also said that the latest talk is “not a decision-making meeting,” The oil producing cartel usually makes important decisions in formal discussions, which usually occur at OPEC’s headquarter in Vienna.
However, even if OPEC members and Russia agree to freeze crude oil volumes, a deal could turn out to be largely meaningless given the major oil producing countries are already pumping near record quantities of crude. Russia, for instance, is pumping close to its highest level in almost a quarter of a century. Meanwhile, the latest oil market report from International Energy Agency shows that major OPEC members - Saudi Arabia, Kuwait, the United Arab Emirates and Iraq – are all producing near all-time high quantities of crude oil while Iran’s is closing in on pre-sanctions level of oil production. At this stage, a production freeze agreement won’t be of any significant help.
What makes this scenario even more uncertain is that the drilling activity in the US, which has seen the largest drop in oil production than any other country in the downturn, is beginning to climb. For 11 out of the last 12 weeks, the US weekly rig count has increased, latest data from Baker Hughes (NYSE:BHI) shows. The uptake in drilling activity could slow down the decline in US production, which could be negative for the oil market.
Meanwhile, the demand for crude oil in the US could fall in the coming weeks while crude inventories could climb, which threaten to bring oil prices lower. The decline in demand will be driven by the end of the driving season within a couple of weeks. Meanwhile, the US refineries, who are the primary buyers of crude oil, won’t be buying as much crude since they have started their maintenance season which will end next month. Meanwhile, oil supplies from the Gulf of Mexico will also likely increase following the end of weather-related disruptions.
Conclusion: Play defense
These factors could drag oil prices in the near future, which could hit oil and gas production stocks. Risk-averse investors should, therefore, continue to play defense by sticking with Exxon Mobil. The company not only has vast non-oil-and-gas-producing (refining and chemicals) businesses which minimize direct exposure to oil prices (as discussed earlier), it also has arguably one of the best balance sheets in the industry.
Exxon Mobil comes with a net debt (debt minus cash) ratio of just 18%. This compares against average ratios of 22% of oil majors, like Chevron (NYSE:CVX), 33% of large-cap exploration and production companies, like ConocoPhillips, and 22% of mid-cap oil producers, like Continental Resources (NYSE:CLR), as per data from an Oppenheimer report emailed to me.
It is also worth mentioning here that although the rating agencies stripped Exxon Mobil of its coveted perfect credit score earlier this year, the oil giant continues to enjoy the highest credit score among all US-listed oil and gas producers. That is also a testament to its strong financial health.
To sum it up, the oil price environment seems to be getting better, particularly with all the excitement around the upcoming meeting between OPEC members and Russia. If oil prices continue to rise, then pure-play oil producers like ConocoPhillips should outperform Exxon Mobil. This, however, does not mean that investors should buy into the optimism and load up on pure-play exploration and production stocks. Rather, investors should remain cautious since the oil market continues to face major headwinds. In an uncertain environment, I believe investors should play defense and stick with Exxon Mobil.